### Chapter 1

```Chapter 11
Capital Budgeting
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Capital Budgeting Process
Plant expansion
Equipment selection
Equipment replacement
Capital budgeting is a decision-making approach
aimed at helping managers make decisions about
investments in major capital assets, such as new
facilities, equipment, new products, and research and
development projects.
Cost reduction
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Capital Investment Decisions
There are two main types of
capital investment decisions.
Screening Decisions
Preference Decisions
Pertain to whether or
not some proposed
investment is
acceptable; these
decisions come first.
Attempt to rank
acceptable
alternatives from the
most to least
appealing.
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Capital Investment Decisions
Capital budgeting decisions can
be placed into two categories.
Independent Projects
Mutually Exclusive
Projects
Projects are unrelated,
so investing in one does
not preclude or
eliminate investing in
the other projects.
Investment choices are
competing alternatives,
to rejection of the
others.
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Capital Budgeting Methods
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Capital Budgeting Methods
To illustrate how the five capital budgeting methods work, assume that managers in
Apple’s iPod division are considering producing a special version of the iPod Touch
that would be marketed to children and their parents. The new device, called the
iKids Touch, would be designed to appeal to children, with durable components,
“kid friendly” controls, and bright colors.
The basic question that
is whether this
proposed project is
worth the \$1 million
up-front investment.
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Learning Objective 11-1
Calculate the accounting rate of
return and describe its major
weaknesses.
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Accounting Rate of Return
Annual
Net
Income
\$108,000
÷
Initial
Investment
=
Accounting
Rate of
Return
÷
\$1,000,000
=
10.8%
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Accounting Rate of Return
Shortcoming and Criticisms
 The time value of money is ignored.
 The accounting rate of return is based on accounting
net income instead of cash flow.
 Depreciation may be calculated several ways
and, in addition, other accounting method
alternatives may have an impact on reported
net income.
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Net Cash Flow versus Net Income
To convert from net income to net cash flow, we must
add back the depreciation that was deducted in the
computation of net income, as shown below.
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Learning Objective 11-2
Calculate the payback period and
describe its major weaknesses.
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Payback Period
Initial
Investment
÷
Annual
Net Cash
Flow
=
Payback
Period
=
3.25 years
Net Income + Depreciation
\$1,000,000
÷
\$308,000
\$108,000 + \$200,000
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Payback Period
When annual cash flows are unequal, the payback period
must be computed on a year by year basis by subtracting
the net cash flow from the unpaid investment balance
each year.
Year
1
2
3
4
5
Starting
Investment
\$ 1,000,000
750,000
450,000
110,000
N/A
–
–
–
–
Annual Net
Cash Flow
\$ 250,000
300,000
340,000
375,000
N/A
=
=
=
=
Unpaid
Investment
\$ 750,000
\$ 450,000
\$ 110,000
\$ (265,000)
N/A
The payback period is somewhere
between 3 and 4 years.
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Payback Period
Shortcoming and Criticisms
 The time value of money is ignored.
 The payback period ignores cash flows
after the payback period.
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Time Value of Money
One dollar received today is worth more than one
dollar received a year from now because the dollar can
be invested to earn interest.
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Time Value of Money
Discounting is exactly the opposite of compounding.
Just as interest builds up over time through
compounding, discounting involves backing out the
interest to determine the equivalent value in today’s
present value dollars.
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Time Value of Money
Discounted Cash Flow Methods
Net Present Value
Internal Rate of Return
Profitability Index
Assumptions:
1.All future cash flows happen at the end of the year.
2.Cash inflows are immediately reinvested in another
project.
3.All cash flows can be projected with 100 percent
certainty.
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Learning Objective 11-3
Calculate net present value and
describe why it is superior to the
other capital budgeting techniques.
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Net Present Value (NPV)
The net present value (NPV) method compares the
present value (PV) of a project’s future cash inflows
to the PV of the cash outflows.
The reason is that
accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
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Net Present Value (NPV)
Chose a discount rate – the
minimum required rate of return.
Calculate the present
value of cash inflows.
Calculate the present
value of cash outflows.
NPV = –
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Net Present Value (NPV)
Relationship Between NPV and
the Required Rate of Return
If the Net Present
Value is . . .
Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the required
rate of return (discount rate).
Zero . . .
Acceptable, since it promises a
return equal to the required rate of
return (discount rate).
Negative . . .
Not acceptable, since it promises
a return less than the required rate
of return (discount rate).
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Net Present Value (NPV)
investment is \$1,000,000, and the product’s estimated life is 5
years. iKids Touch’s required rate of return is 12%. iKids Touch
estimates the new product will generate \$308,000 in cash
flow for each of the next five years.
Since the NPV is positive, we know the rate of return
is greater than the 12 percent discount rate.
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Net Present Value (NPV)
Assume that the expected cash flows for the iKids Touch
project for years 1 to 5 are \$250,000, \$300,000, \$340,000,
\$375,000, and \$300,000, respectively. The project will still
require an investment of \$1,000,000 and the cost of capital
is still 12 percent.
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Computing NPV in Excel
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Relationship Between NPV and
Discount Rates
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Learning Objective 11-4
Predict the internal rate of return
and describe its relationship to net
present value.
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Internal Rate of Return (IRR)
The internal rate of return is the interest
rate that makes . . .
 Present
value of
cash inflows
=
Present
value of
cash outflows
 The net present value equal zero.
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Computing IRR in Excel
One important note about the IRR function is that you must
include the original cash outflow in the calculation.
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Internal Rate of Return (IRR)
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Profitability Index
The profitability index is the ratio of a project’s benefits
(measured by the present value of the future cash flows) to
its costs (or required investment).
Profitability Index > 1 = Project Acceptable
Profitability Index < 1 = Project Unacceptable
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Comparing Capital Budgeting Methods
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Learning Objective 11-5
Use the net present value method to
analyze mutually exclusive capital
investments.
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Case 1: Lease or Buy Equipment
iKids Touch is trying to decide whether to buy a new
copier or lease it from a copier company, and has
gathered the following information about the two
options:
iKids Touch uses net present value to evaluate
investment options. If the discount rate is 10%,
should the company lease or buy?
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Case 1: Lease or Buy Equipment
To analyze this decision, we can use the NPV method to
compare the relevant costs (in present dollar values) of
each option.
Lease option costs \$1,419 less.
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Case 2: Investing in Automation
iKids Touch is thinking of spending \$10,000,000 to
automate a production facility. The investment is
expected to have the following effects:
• Automation
will increase the capacity of the plant and allow it
to boost production and sales by 20 percent.
•The company will be able to reduce packaging labor cost per
unit by 30 percent.
•Factory supervision costs will increase by \$500,000 per year.
•The estimated useful life of the equipment is six years, at which
point it will have a residual value of \$1,000,000. Straight-line
depreciation of the assets will be \$1,500,000 per year
[(\$10,000,000 – 1,000,000) ÷ 6 years = \$1,500,000].
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Case 2: Investing in Automation
This table summarizes the effects on net income. The per-unit costs
in the first column are assumed. Note that automation increases net
income by \$1,100,000.
iKids Touch uses net present value to evaluate
investments. If the discount rate is 12%, should
the company make the \$10,000,000 investment?
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Case 2: Investing in Automation
Remember that the net present value method is based on cash flow
rather than net income. So, we need to add back the depreciation (a
noncash expense) to net income to get net cash flow. We also need
to incorporate the initial investment (at time zero) and the salvage
value of the machinery at the end of six years.
The positive net present value of \$1,196,240 means that the
proposed investment in automation will generate a return in excess
of the 12% cost of capital.
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Learning Objective 11-6
Use the profitability index to
prioritize independent capital
investment projects.
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Prioritizing Independent Projects
The profitability index is used to prioritize
capital investment projects.
Profitability
Index
=
Present Value of
Future Cash flows
÷
Initial
Investment
When using the profitability index to prioritize
projects, the preference rule is: the higher the
profitability index, the more desirable the project.
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Prioritizing Independent Projects
iKids Touch is trying to decide how to prioritize their limited
research and development budget. They are
considering these three independent projects.
How should iKids Touch prioritize these three projects?
A, then B, then C
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Supplement 11A
Time Value of Money
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Learning Objective 11-S1
Use present value and future value
tables to incorporate the time value
of money.
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Time Value of Money
Future
Value of
a Single
Payment
Present
Value of
a Single
Payment
Future
Value of
an
Annuity
Present
Value of
an
Annuity
Present and future value
problems may involve two
types of cash flow: a single
payment or an annuity (a
fancy word for a series of
equal cash payments)
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Future Value of a Single Amount
To solve a future value problem,
you need to know three things:
1.Amount to be invested.
2.Interest rate (i) the amount will
earn.
3.Number of periods (n) in which
the amount will earn interest.
Using Table 11.1A.: \$1,000 × 1.3310 = \$1,331
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Present Value of a Single Amount
The present value of a single
amount is the value to you today of
receiving some amount of money
in the future. To compute the
present value of an amount to be
received in the future, we must
discount (a procedure that is the
opposite of compounding) at i
interest rate for n periods.
Assume that today is January 1, 2013, and you have the opportunity to receive
\$1,000 cash on December 31, 2015 (three years from today). At an interest rate
of 10 percent per year, how much is the \$1,000 payment worth to you on January
1, 2013 (today)? You could discount the amount year by year, but it is easier to use
Table 11.2A , Present Value of \$1.
Using Table 11.2A.: \$1,000 × 0.7513 = \$751.30
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Future Value of an Annuity
The future value of an annuity
includes compound interest on
each payment from the date of
payment to the end of the term of
the annuity. Each new payment
accumulates less interest than
prior payments because the
number of periods in which to
accumulate interest decreases.
Assume that each year for three years, you deposit \$1,000 cash into a savings
account that earns 10 percent interest per year. You make the first \$1,000
deposit on December 31, 2013, the second one on December 31, 2014, and the
third and last one on December 31, 2015. To calculate the future value of this
annuity, use Table 11.3A , Future Value of an Annuity of \$1.
Using Table 11.3A.: \$1,000 × 3.3100 = \$3,310
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Present Value of an Annuity
The present value of an annuity is
the value now of a series of equal
amounts to be received (or paid
out) for some specified number of
periods in the future.
Assume you are to receive \$1,000 cash on each December 31 for three years:
2013, 2014, and 2015. How much would the sum of these three \$1,000 future
amounts be worth on January 1, 2013, assuming an interest rate of 10 percent per
year? To calculate the present value of this annuity, use Table 11.4A , Present
Value of an Annuity of \$1.
Using Table 11.4A.: \$1,000 × 2.4869 = \$2,487 (rounded)
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End of Chapter 11
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```